Investors should reconsider their likely under allocation to Japanese equities and how that investment is expressed, focusing on long-term allocations, and including domestic as well as multi-national companies.
Japan has long been a disappointing market for global investors, with annualized 15-year returns of 6.4% (in U.S. dollars) versus 13.7% in the U.S. Slow growth, negative interest rates, lack of focus on shareholders, and better opportunities elsewhere in Asia kept investment dollars away from Japan. Investors tended to look at Japan tactically, to play a weakening Yen by buying Japanese exporters. But this story is rapidly changing: Japanese equities are up 15.5% year-to-date (in U.S. dollar terms), but this masks even stronger local currency performance of 28.8%. Increasingly, global investors are taking another look at boosting strategic allocations to Japan, including to more domestically oriented companies. Is this enthusiasm justified? Key structural shifts are taking place that justify a closer look at Japanese equities going forward, including higher nominal growth, positive interest rates, corporate governance reforms, and a shift in flows away from China.
- Higher nominal growth and positive interest rates: For decades Japan has battled deflation, but since the pandemic, Japan has welcomed the return of inflation, with October core CPI reaching 4.0% y/y. A virtuous cycle seems to be taking hold: higher prices driving higher wage growth which drives prices higher. This more long-lasting uplift in wages and prices would imply higher revenue growth for domestically oriented companies, especially consumer ones. Another implication of positive inflation is the eventual end of negative interest rates (the reality in Japan since 2016). The Bank of Japan has already started its long journey of policy normalization, first by relaxing its control of the yield curve this year and likely raising short-term interest rates next year. The shift from negative to positive interest rates is a game changer for Japanese banks, which would be able to earn interest on excess reserves and be able to charge higher rates on loans. This explains the 23% gain of Japanese banks year-to-date.
- Corporate governance reforms: Currently, 35% of Japanese companies have a price-to-book ratio below 1x, suggesting a poor investment, versus 19% in Europe and 1% in the U.S. Historically, this has occurred due to Japanese companies’ lower focus on shareholders – but this is changing. In April, the Tokyo Stock Exchange implemented corporate governance reforms aimed at increasing shareholder value: companies with a price-to-book ratio below 1x must create a plan to increase their value for shareholders or face delisting. One example is boosting share buybacks, with activity reaching a 10-year high in fiscal year 2023. Japanese companies (ex. financials) still have 49% cash on their balance sheets as a % of net assets, leaving plenty of room for further increases in shareholder returns.
- Shift in flows away from China: For years, Chinese markets sucked in a lot of flows in the Asia region. Given challenges with recent performance, combined with rising geopolitical tensions, investors around the world have begun to diversify flows into other markets, with Japan and India top of mind.
The change in the Japan’s nominal growth picture, combined with governance reforms and shifts in capital flows, suggest the 25% P/E discount of Japanese equities relative to U.S. equities is no longer justified. Investors should reconsider their likely under allocation to Japanese equities and how that investment is expressed, focusing on long-term allocations, and including domestic as well as multi-national companies.